At Farm Credit East, we are often asked about equipment purchases – what constitutes a “major” equipment purchase, how to plan for them, and whether to buy new or used. Paul VanDenburgh, an experienced credit officer and tax specialist, recently provided his insight on some of these frequently asked questions.
What types of equipment would you classify as major equipment purchases?
It varies by the size of your farm. You could set a threshold dollar amount, say, $10,000 or more, but more often than not, I would say anything that you’re going to finance is considered “major” for your business and worth giving some thought to.
How often should a farm plan to replace those pieces of equipment?
This will vary quite a bit by the type of equipment we are talking about. Different types of equipment have different useful lives, and it also depends on how hard you run them. A tractor might last for 20 years if you’re only using it occasionally, or you could burn through it in less than five years if you’re putting a lot of hours on it.
For me, the major consideration would be maintenance and repairs, and the associated downtime. If you’re spending anything close to what the payments on a new(er) unit would be on repairs, I would think about upgrading. Is the unit “mission-critical” for your business? Is the new equipment safer? In that case I would upgrade sooner. If the equipment brings savings or new capabilities to your business, then you need to evaluate those benefits.
How do you advise farms to financially plan for replacement of major equipment?
Consider what you are expensing in depreciation. Depreciation is basically a monetary calculation of how fast your equipment (and facilities) are wearing out. You may not need to invest exactly that amount, but it can be a rough guide for some farms. Most farms will actually invest more than depreciation in capital purchases because equipment costs are increasing all the time.
Partial budgeting can be a useful exercise.
- What additional income will this purchase generate (if any)?
- What costs will be reduced or eliminated?
Balance that against:
- What additional costs will this purchase generate?
- What changes to my income will occur because of this purchase (if any)?
What advice can you offer to farms considering major equipment purchases this year or in 2018?
You may want to be cautious about buying equipment for “tax purposes”. I sometimes see farms making major investments to get a direct expense or Section 179 write-off or something similar, but make sure that these purchases aren’t a case of the “tail wagging the dog”.
In other words, is the business spending more than it has to on things that are not the best investments for the farm? Additionally, I advise against taking a direct expense on an asset acquired with loan proceeds. You may pay very little tax the year of purchase, but you set yourself up for a shocker in future years. You need profits to pay the loan payments and you won’t have a depreciation expense to offset that profit. Sometimes it’s better to pay a little bit in taxes and forego a big purchase that doesn’t need to be made. Ideally, even if you are investing to offset tax liability, you should have thought things through ahead of time, and are making purchases that are strategic for your company.
Also, consider your ability to make payments during an industry downturn.
What are the advantages and disadvantages of buying new vs. used major equipment items?
“New vs. Used” is always a debate. New, of course you will typically have fewer repairs and down time, plus you’re getting the latest technology. But you pay for that. Again, it will depend on how big your farm is, how big the investment is and how much you plan to use it.
When financing, keep in mind a few things. Equipment manufacturers may offer enticing financing packages on new units (i.e. a low or even zero rate of interest), but these may not always be as great as they seem. You might pay a higher price for the unit than you would if you got your financing elsewhere. Don’t get me wrong – there can be some good offers, particularly in a slow sales period, but ask if taking the financing deal will affect the price of the unit.
Don’t finance equipment for longer than its expected useful life! If you do, you could end up in the unenviable position of having to still make payments on a unit that needs replacement. Plus, in the later years of the financing window, typically your warranty has expired, and you may be facing increasing repair costs as well as payments, making that unit very expensive to own. If you can’t cash flow the finance payments for roughly 2/3 of the units’ useful life, I would question whether that purchase makes sense.
Farm Credit East tax experts are up to date with the tax laws affecting ag, forestry and commercial fishing businesses. Our specialists can address virtually all of your business concerns, including questions on equipment purchases, and are available to you throughout the year to analyze and discuss year-to-date activities, tax saving strategies and the tax consequences of every business decision or purchase. Get in touch today.